Wednesday, February 3, 2016

Concentrated versus Diversified Dividend Investing

Some of the best investors in the world, Charlie Munger and Warren Buffett, have been able to make it by having a concentrated portfolio of securities. Their thinking is that investors who are willing to work hard at investing game should concentrate their bets in their best ideas. It is difficult to argue with the results from those two investing titans. It makes sense that if you really know what you are doing, you should concentrate your portfolio in just a few companies, because the effect on the portfolio will be much more pronounced. For example, if you were smart enough to identify Wal-Mart (WMT) at the time it became a dividend achiever in 1984 - 1985, your portfolio would have done much better if you put a higher weighting to this retailer.

For the know something or know nothing investor however, their advice has been to diversify extensively. Today I am going to discuss why I decided to diversify extensively. This is because I acknowledge that I am not Buffett. I also acknowledge that forecasting the future is difficult, since things can change no matter how much research and conviction behind that research I have.

As I explained in an article a while ago, the number of companies in my portfolio has been increasing rapidly since late 2012 and early 2013. Many readers ask me why I don’t simply sell off a portion of those positions and concentrate my portfolio in my best 15 – 20 ideas. In addition to my response , which is still relevant, I will try to add a more honest twist to it.

I started dividend growth investing in 2008, and launched my site at the same time in order to make myself do the necessary work and also journal ideas about my strategy and goals. I never expected the site to get to be as popular as it is today, but a very big plus for me has been the ability to interact with like minded investors.

For the first three or four years, I generally built my portfolio around the same 30 or 40 companies. Over the past 3 - 4 years however, most of the usual suspects I followed and invested in have become overvalued. This prompted me to buy into more companies that I never before owned, but which provided very attractive entry points. Regular readers know that I tended to put a set amount of money to work every month, after an extensive screening and research exercise. This means that I need to put the money to work at the best possible opportunities at the moment.

In the past seven-eight years, I made mistakes such as selling to early at times, but most of the time I did fine. As I kept spending more time investing and evaluating my results however, I noticed that the companies that delivered the best growth in terms of share price and dividends tended to be companies, which were outside my entry criteria or close to breaking them. In other words, the best investment ideas that I had and to which I put a large portion of the capital I had did not do as well as my next best ideas. This is a very interesting phenomenon, since it ran counter to what Buffett and Munger preach.

For example, back in 2011 I bought shares of Visa (V) for about $32/share. I got in at a dividend yield below my minimum requirement, but at a P/E below 20. I also did very well buying Family Dollar (FDO) at 2% yield in 2008, which then kept raising dividends and tripled in price. Those companies were yielding less than my minimum requirements at the time, yet they performed much better than many of those which fit my requirements. I noticed this early on, and kept on testing to see if this is a trend or a fad. I could go on and on about companies I had purchased below my entry yield, which did really well after that. So no, it was not a fad, but a trend.

This is why I am not interested in concentrating in my best ideas. It seemed that my best ideas were in retrospect not the most optimal uses of capital. If I hadn’t questioned myself beyond those best ideas, I would not have been as successful as I am today. In addition, I am also hesitant about selling portions of my portfolio in order to concentrate on those best ideas and reduce the number of securities to a more manageable level. To me, selling a perfectly reasonable company that at least maintains dividends is a mistake, that is compounded by taxes and reinvestment risk.

I have learned that selling a company is usually a mistake, at least per my experience. I would have been much better off just staying in the original company, even if it “looked” overvalued. This is because by selling, I miss out on any potential new gains in dividends and capital gains, I also pay taxes, commissions and might end up in a company which is actually a worse investment than the original one I sold.

After learning from my mistakes, I have been hesitant to sell companies like Colgate-Palmolive (CL), Automatic Data Processing (ADP) or Brown-Forman (BF.B). As a result, those compounders have done really well. This is why I am not going to sell companies that might not fit my entry criteria today, merely to concentrate on my best ideas. This is because my best ideas might or might not turn as good as the sold ideas whose capital those best ideas end up using. As I have said before, I am not Buffett. Anyone who claims to be Buffett (whether directly or indirectly) but lacks the investment record to back up their claim is likely a fraud that is after your money.

I also managed to spend quite a lot of time learning about other businesses in the past few years, which has increased my business knowledge and desire to buy those permanent positions. The thing is that I was extremely busy/booked between 2010 and 2012, which meant less time to dedicate to this site and my investing. However, the nature of quality dividend stocks is such that they do not require much tending. I hear people ask me how I keep up with so many companies, and my response is always that of surprise. As a long-term investor, I try to pick companies that can sit in a portfolio for 10 -15- 20 years, without me needing to do anything other than cash those dividend checks. Not all will succeed, and some will fail, but that is something that will happen either way no matter how much tending I do. I could theoretically sell a company stock if I see it running into trouble, but then I am risking selling out during a temporary dip in business, which is then reversed. That being said, I do check annual financials that come out from companies I own, and check for significant and material events such as dividend increases, mergers and acquisitions, spin-offs to name a few.

Reviewing those takes less than 5 – 10 hours/week, although this is also intermingled with me trying to type up something for this site, as well as looking up prospective dividend ideas. But either way, I believe that if I am no longer here tomorrow, my portfolio will keep spitting out higher dividends to whoever inherits it, for several decades into the future. Whoever inherits my portfolio will not need any knowledge, since they will receive dividends every month, and if a company cuts dividends, they will receive the capital and any gain back.

The thing I am trying to say is that you might have all the information in the world, and all the beliefs about something. However, the future is largely unknown, which is why it is good to have exposure to different types of companies and have a diverse portfolio. It is also important to keep learning new information, and try to implement it to your own situation. Being arrogant, and thinking that you know it all is actually a very dangerous type of mindset to be in. You need to be humble, and constantly evaluate the evidence you have at your disposal. If your picks are not doing as well as expected, you need to reassess your way of doing things. For example, if you consistently end up buying high yielding companies which end up cutting dividends or failing to raise them, you might need to reassess your strategy.

This is one of the reasons why I am increasing the number of companies in my portfolio. At the end of the day, no matter how much analysis you do, things can change that can prove your original thesis void. I am also coming up to the stage in the game where capital preservation is also important to me. I would much rather end up compounding my money at 8% for the next 40 years with more companies and less risk of failure ( failure = permanent loss of capital), than shoot for the stars and compound at 15% per year but high risk of failure. At this stage of the game, I do not believe to be as good as Buffett at picking investments. And neither are 99.90% of investors who are reading this site (sorry Warren).

With that being said, I am keeping the type of portfolio I have. I am essentially having three types of buckets in my dividend portfolio. The first bucket includes the types of low growth but higher yielding companies such as Realty Income (O).

The second bucket includes companies in the sweet spot of moderate yields and moderate dividend growth such as PepsiCo (PEP) or Walgreen (WBA).

The third bucket includes companies with low current yields but high expectations for dividend growth such as Visa (V).

The larger change I have made in the past two- three years is focusing more on tax-deferred investing. Fortunately or Unfortunately, this limits me in the types of investments I can make. For my 401 (k) and HSA, I am limited to low cost index funds. While the total returns of my individual stock picks have been fairly close to those of a diversified index portfolio over time, what really sold me on tax-deferred accounts is the ability to save as much as 25% - 38% right off the bat with those 401 (k) and HSA plans. Ironically, rational capital allocation does not translate into more readership. But it does translate into more money and more future dividends for me.

So to summarize, for most investors out there, the best solution for investing money is to be as broadly diversified as possible. This includes not only having at least 50 - 60 dividend stocks, but also some fixed income, maybe even own your home too if prices are reasonable. If you are truly honest with yourself, you would know that a concentrated portfolio could have a higher chance of permanent capital impairment, no matter how much research you do. Of course, if you are a truly talented investor, do not let me get in the way of your success. Just be careful and make sure that you are fine going back to zero if you are wrong.

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